From the October 01, 2010 issue of Futures Magazine • Subscribe!

Options writing mistakes to avoid

In today’s volatile and unpredictable markets, option selling is becoming a popular choice among high net worth investors and traders. This has been mainly because of the strategy’s high probabilities of success on individual trades, ability to generate reliable income and positive performance in all types of market conditions.

But while option selling can be a powerful way to diversify into a non-correlated, non-directional strategy, there is no free lunch. Writing options is one of those strategies that is easy to understand but infinitely more difficult to master. Option selling, especially in commodities, has its own set of risks. Knowing how to deal with them should allay any fears you may have about selling premiums and boost your bottom line.

When considering whether or not to allocate capital to an option selling portfolio, many of the resources you may have access to describe a recommended way to go about selling options. Whether you hire a professional manager or attempt to go it alone, knowing what to do seems to take precedence over what not to do.

Experience shows, however, that not doing the wrong things will have as much, if not more, an impact on your portfolio’s ultimate performance than doing all of the right things. Therefore, we can learn a lot from the errors of others. To that end, we’ll explore the three biggest mistakes that option sellers make and, more importantly, discuss simple ways to avoid making them.

Mistake one: Over-positioning

Over-positioning is the biggest mistake new option sellers make. Most brokers servicing self-directed clients will see this again and again. No matter how much you school them on how to sell options, it is difficult to teach somebody how to position.

Typically, this is how it works: New traders sell a few options, see them decay and get excited thinking they have found the Holy Grail of investments. They proceed to ramp their activity to ridiculous levels, selling far too many options relative to their account size and end up with either too many options for their account or too concentrated in a particular market or sector. This puts the whole portfolio at greater risk of taking losses. Option selling works but you have to understand and respect the leverage. Remember you are supposed to be right most of the time in premium selling but at some point you will take a loss and you can’t let that loss wipe you out.

This also goes back to the trader versus investor mentality. Option selling can sometimes be detrimental to active traders. Traders want to (and sometimes think they have to) trade every day. Option selling is more of a passive activity that requires mostly time and patience. This puts the strategy at odds with active traders that like a lot of action.

Some simple guidelines can go a long way toward protecting against over-leverage: Keep 50% of your account capital in cash and diversify your other 50% among at least six to eight commodities, puts and calls using a mix of naked and spread strategies. This portfolio structure is based on many years of experience managing propriety and client funds. Use it and you won’t make the mistake of over-positioning. While the vast majority of professional option writing managers concentrate on stock index markets, diversifying across commodities provides more variety and allows you to better take advantage of mispriced premium levels, particularly some seasonal mispricing that often occurs in certain agricultural markets.

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